Does Inflation Make Bonds Attractive?

by Geri Terzo

Too much inflation can have damaging effects not only on bonds but an entire economy. Certain bonds are designed to withstand inflation better than others. When economic conditions are aligned just right, inflation might make certain types of bonds seem attractive. The primary effect of inflation on bonds, however, is harmful. Inflation reduces the buying power of a currency, including the U.S. dollar. Bond investors are paid income based on inflationary conditions at the time of the investment, and if inflation rises, the value of the fixed income falls.

High-Yield Bonds

In an economic environment when short-term interest rates, which are set by the Federal Reserve, are low, indications of rising inflation could benefit high-yield bonds. These bonds have high interest rates attached but are considered risky based on the likelihood of default. U.S. and emerging market high-yield bond prices may rise in an escalating inflationary environment when short-term rates are low, according to a 2011 article on the Minyanville website. The article suggests it is cheaper for high-yield bond issuers to service debt, or pay investors interest and other bond income, in an inflationary environment.

Features

The features of a bond security have direct exposure to inflation. A bond has a price and a yield, which is the interest rate that determines an investor's return based on the security's price. Bond rates and prices move inversely, and inflation has a tendency to drive rates higher and prices lower, according to the Fidelity Investments website. Interest rates on traditional bonds are often often locked in and may not affect the size of a distribution. Nonetheless, higher inflation means that the income that an investor earns on a debt security is worth less than it was before.

Opportunity

There is a way for investors to safeguard against inflation and attempt to earn returns in the meantime. The U.S. government created debt securities that are designed to protect investors from inflation. Although the returns on these Treasury securities are somewhat modest, TIPS are largely considered safe investments that are nimble enough to adjust with the changing rate of inflation. Investors directed $105 billion into TIPS over the 12-month period ending in July 2011, according to" U.S. News and World Report."

Long-Term Rates

Rising interest rates on long-term bonds could be an indication of higher inflation, according to a 2011 article in "The Wall Street Journal" titled "Bond Market Flashes Inflation Warning." In February 2011, when interest rates on long-term government bonds began escalating quickly, fear spread through the markets that U.S. monetary policymakers were not responding appropriately to coming inflation. Bond investors look to policymakers to keep short-term interest rates low when inflation is looming.

About the Author

Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.

Photo Credits

  • Stockbyte/Stockbyte/Getty Images